21.12.2022.

Borrowers in the midst of rising costs: what is the capacity of household borrowers to withstand the sharp increase in prices and interest rates?

Illustrative picture: worried people looking to the bills
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The impact of the pandemic on the financial situation of households has been relatively uneven; however, their solvency and financial resilience have overall improved since the onset of the pandemic and were high midway through this year.

In short

  • The impact of interest rate hikes on the households' ability to fulfil their debt obligations is expected to be moderate, while that of consumer price surges is projected to be significant. 

  • One out of ten households might face an excessive debt burden as a result of higher prices and interest rates . The risk of an excessive debt burden is reduced by rising employment income, sizeable government support measures and savings.

  • The vulnerability and insolvency risks of a small part (5%) of households are high; nearly a half of them are the lowest-income households. The share of housing loans granted to these households in the aggregate portfolio of housing loans constitutes 4%.

In the second quarter of 2022, the average monthly household employment income in real terms (calculated in the price level of the second quarter of 2022) showed a 6.3% increase or an average 158 euro increase per household compared to the second quarter of 2020 [1] . Meanwhile, household deposits with monetary financial institutions per household in the price level of the second quarter of 2022 grew by 2148 euro in comparison with the same period two years ago. In the second quarter of this year, the debt service burden of households reached a historical low [2] ; the interest payment discipline also remained very good.

With consumer prices rising more rapidly than wages and with interest rates continuing to increase, the solvency of household borrowers is deteriorating. This article assesses the financial resilience of household borrowers by analysing the data on household income, spending, loan commitments and savings collected by Latvijas Banka's fourth survey of household borrowers [3] . The validation of the results reflecting the impact of interest rates on credit payments was subject to an additional analysis using the data from Latvijas Banka's Credit Register.

The impact of energy price hikes is significantly reduced by the government support measures: during the current heating season, they amount to 3.0%, while in the previous heating season they accounted for 1.0% of the household disposable income of 2021 (see Table 1). The total allocated amount of all support measures for both heating seasons is, on average, approximately 1081 euro per household. Moreover, a substantial part of the support measures to compensate for energy price hikes also affect the most well-off households representing a higher share of borrowers. Household solvency assessment takes into account the government support for the compensation of the energy price increase [4]  as well as the impact of the pension indexation [5]; however, the lack of detailed data does not allow assessing the impact of other social benefits. It should be noted that the share of recipients of these benefits among households with a housing loan is most likely to be small.

Table 1. Support measures directly applicable to households to partially compensate for energy price hikes (millions of euro)

  Heating season 2021/2022 Heating season 2022/2023 Total
Dampening the effect of prices (to compensate for the effect of electricity, natural gas, centralised heating, firewood, briquette and wood pellet price hikes) 54 510 565
Social benefits (housing benefits, pension indexation, target subsidies, premiums, lump-sum payments) 173 155 328
Total 227 665 892
% of the disposable household income in 2021
Dampening the effect of prices (to compensate for the effect of electricity, natural gas, centralised heating, firewood, briquette and wood pellet price hik 0.2 2.3 2.6
Social benefits (housing benefits, pension indexation, target subsidies, premiums, lump-sum payments) 0.8 0.7 1.5
Total 1.0 3.0 4.1

Sources: Ministry of Finance, Ministry of Economics, Ministry of Welfare, Latvijas Banka's calculation.
Data compiled on 17.11.2022.

The assessment of the increase in household debt service expenditure and everyday spending is based on the following assumptions.

  • In late 2022, EURIBOR reference rates of all terms rise to 3.0% [6] . Until then, households continue to service their debt in accordance with the current repayment terms.
  • Monthly service payments for loans, other than housing loans, do not change in 2022 [7] .
  • Household spending on utility payments in 2022 rises according to the growth in the energy component of the consumer price index, spending on food – in line with the growth in the food component, while other expenditure rises according to the growth in service prices or the total growth in consumer prices. As a result, total household spending increases correspondingly to the total growth in consumer prices. Households do not change their consumer basket in 2022.
  • Household income in 2022 rises in accordance with Latvijas Banka's forecast about the average wage growth in the country.

Impact of interest rate hikes

Data from both Latvijas Banka's survey of household borrowers and Latvijas Banka's Credit Register show that monthly debt service payments for most households would see a relatively small rise, i.e. less than the average growth in income generated from employment in real terms per household since the onset of the pandemic. According to the estimates based on the data from Latvijas Banka's Credit Register, the calculated monthly debt service payment rise is smaller than 160 euro for 91.5% housing loans; while, according to the data from the survey of household borrowers, this is true for 86.2% housing loans. According to both sources, for more than half of housing loans, the expected increase in monthly loan service payment will not exceed 60 euro per month.

 

Note. The information included in Latvijas Banka's Credit Register reflects an increase in payments for all housing loans with a floating rate, EURIBOR reference rate and a fixed and declining balance amortisation schedule: 72 023 housing loans (in total) on 31 March 2022. Due to a larger number of observations, the distribution of the rise in payments is more even than in the estimates obtained from the household borrower data.

It is expected that the monthly debt payments will grow more significantly for housing loans granted in the recent years (see Chart 2). There are at least two reasons for this finding. First, housing loans with a declining balance amortisation schedule see larger monthly payments and a larger impact of increased interest rates at the start of the loan repayment schedule. Second, with real estate prices increasing and due to a trend for households purchasing more spacious housing emerging during the pandemic, the number of larger new housing loans has increased, thus also implying larger monthly service payments and a more significant impact of higher interest rates.

 

Note. The data from the survey of household borrowers are grouped in wider intervals, as the number of observations in some years when loans have been granted is small.

Impact of the surge in consumer prices

The impact of growth in daily expenses on solvency is relatively smaller for households with housing loans granted in the recent years (see Chart 3). This could be explained by the fact that, in recent years, a significant part of liabilities, including the larger housing loans, have been taken on by the most well-off households that witnessed a continued rise in their income during the pandemic [8] . This year, expenditure on food and utility payments is seeing a greater surge than the overall consumer prices, and for the wealthiest households they represent a relatively smaller share of total income.

 

The rise in daily expenses mostly affects the solvency of the lowest-income households (1st income quintile). Utility payments and spending on food for household borrowers with income corresponding to 1st income quintile [9] form a relatively large part of all spending and income, thus their sharp climb significantly affects the solvency of these borrowers (see Chart 4). The burden of everyday spending increase for the wealthiest household borrowers (5th income quintile) is 1.5 times lower than for the lowest-income households if measured relative to their income.

 

Assessment of the debt burden

The impact of interest rate hikes on the households' ability to fulfil their debt obligations is expected to be moderate, while that of consumer price surges is projected to be significant. Their overall impact significantly increases the household debt burden.

However, debt burden is expected to become excessive for a relatively small part of households with a loan for house purchase. After the increase in interest rates and spending, 10% of household borrowers are expected to exceed the threshold of 40% [10] for the debt service-to-income (DSTI) ratio. The share of housing loans granted to these households in total loans for house purchase would be 9% (see Chart 5). For comparison, Latvijas Banka's survey of household borrowers conducted in 2011 showed that the debt service costs exceeded 40% of income for 23% of households.

 

* Debt service costs reflect the total expenditure of a household borrower on all its loan commitments. Income reflects the household's overall net income, including from benefits and pensions. In the calculation's first two columns from the left, income is not adjusted. In the calculation's next two columns, income is reduced by the sum by which the respective household's expenses rose in 2022; such approach is used to hypothetically demonstrate how the rise in daily spending weighs further on the households' ability to settle their loan commitments. This income adjustment is not typical and does not reflect the standard approach of credit institutions for evaluating the DSTI ratio.

For the lowest-income borrowers debt burden is expected to become heavier and increase more rapidly. After the climb in the costs and interest rates 17% of the 1st quintile households would see their debt service payments exceeding 40% of their income (see Chart 6). The share of housing loans granted to the 1st income quintile household borrowers is 14% in the aggregate portfolio of housing loans and 2% in the entire portfolio of household borrowers. It is mostly the rise in utility payments and spending on food that makes the debt burden excessive. If households have an opportunity to adjust this spending, the debt burden could be decreased.

 

* Debt service costs reflect the total expenditure of a household borrower on all its loan commitments. Income reflects the household's overall net income, including from benefits and pensions. In the calculation's first two columns from the left, income is not adjusted. In the calculation's next two columns, income is reduced by the sum by which the respective household's expenses rose in 2022; such approach is used to hypothetically demonstrate how the rise in daily spending weighs further on the households' ability to settle their loan commitments. This income adjustment is not typical and does not reflect the standard approach of credit institutions for evaluating the DSTI ratio.

Savings reduce risks, but only partially

Among those 10% of households that would experience the calculated DSTI ratio rise above 40% after the growth in interest rates and spending:

  • for 24% of these households, the level of savings at the moment of the survey [11]  would compensate for the 12 months growth in spending and interest rates;
  • for a significant part (46%) of these households, the level of savings would not even cover a month's worth of the spending and interest rate increase.

Among the 17% of the 1st income quintile households whose DSTI ratio rises above 40%, the level of savings for most (59%) of them does not cover a month's worth of the uptrend in spending and credit payments.

The risks of insolvency are high for households whose debt service burden exceeds 40% after a climb in spending and interest rates and whose savings would not even compensate for a month's worth of the rise in spending and credit payments. Such households make up 5% of all households, and the share of their housing loans in the total loans for house purchase constitutes 4.0%. Nearly a half (43%) of these households are the lowest-income (1st quintile) households.

Conclusions

Overall, household savings, increasing employment income and significant government support measures substantially reduce the negative impact of the rise in prices and interest rates on solvency. According to the calculations, the debt burden resulting from the growth in consumer prices and interest rates becomes excessive for a relatively small part (10%) of household borrowers. Half of these households would be capable to partially compensate the increase in their spending by savings. A small part (5%) of all household borrowers face high insolvency risks, since their income is low and savings are insufficient or non-existent. The share of housing loans granted to such households in the aggregate portfolio of housing loans is small – 4%.

 

 

[1] See below for the assumptions about growing interest rates and costs used in the calculation.

[2] In the second quarter of 2022, the net wage bill exceeded the level of the second quarter of 2020 by 26.6%. In contrast, the growth in consumer prices in the respective period reached 19.1%. According to the CSB data, there were 825.2 thousand households in Latvia in early 2022. It is important to point out that this calculation reflects the average situation; the impact of the pandemic on households has varied significantly.

[3] Household interest payments to banks accounted for only 0.53% of GDP which is the lowest level observed since 2014.

[4] The survey was conducted from September 2020 to February 2021. Household income, including from benefits, and spending for 2021 have been modelled in the same way as in the assessment of household borrowers in the Financial Stability Report 2022: https://datnes.latvijasbanka.lv/fsp/FSP_2022_en.pdf

[5] The increase in household spending has been projected using Latvijas Banka's forecasts for the consumer price growth for energy, food and services and for consumer prices overall. These forecasts also include the impact of the 3rd package of the government support measures.

[6] For households with at least one member receiving a pension, the general index of 1.2287 was applied when indexing pensions in 2022.

[7] This assumption resembles the financial market expectations on 22 November of this year regarding EURIBOR for early 2023. See, for instance, https://www.chathamfinancial.com/technology/european-forward-curves.

[8] Loans to households, other than loans for house purchase, mainly include consumer loans. Such loans mostly have fixed interest rates.

[9] For example, in 2020, the largest loans were granted to the wealthiest households with net monthly income per household exceeding 2000 euro. 45% of these households witnessed an uptrend in income, while only 17% of households saw a drop which was mostly minor. See more in the assessment of household borrowers in the Financial Stability Report 2022: https://datnes.latvijasbanka.lv/fsp/FSP_2022_en.pdf

[10] Debt service costs are seen as possibly excessive if they exceed 40% of the borrower's income. This limit is incorporated into the section "Creditworthiness assessment of consumers" of the FCMC Regulation No 242 "Regulation on Credit Risk Management".

[11] Since the conduct of the survey, savings have, most likely, increased both owing to the government support measures and income rise (and more limited spending opportunities during the pandemic). However, the impact of the income rise and support measures has already been reflected in the projection of household income; therefore, the analysis is focused solely on the initial savings of households.

APA: Semjonovs, A., Āriņš, M., Siņenko, N. (2023, 04. feb.). Borrowers in the midst of rising costs: what is the capacity of household borrowers to withstand the sharp increase in prices and interest rates?. Taken from https://www.macroeconomics.lv/node/5793
MLA: Semjonovs, Andrejs. Āriņš, Mikus. Siņenko, Nadežda. "Borrowers in the midst of rising costs: what is the capacity of household borrowers to withstand the sharp increase in prices and interest rates?" www.macroeconomics.lv. Tīmeklis. 04.02.2023. <https://www.macroeconomics.lv/node/5793>.
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